The Pricing of Quanto Options: An empirical copula approach

TL;DR

This paper introduces an empirical copula approach to price quanto options, emphasizing the importance of dependence modeling between underlying assets and exchange rates, leading to notable pricing differences from traditional models.

Contribution

It proposes a novel empirical copula method for quanto option pricing, capturing dependence structures more flexibly than existing models.

Findings

Pricing differences are significant compared to traditional models.

Empirical copulas effectively model dependence in cross-currency derivatives.

The approach enhances accuracy in quanto option valuation.

Abstract

The quanto option is a cross-currency derivative in which the pay-off is given in foreign currency and then converted to domestic currency, through a constant exchange rate, used for the conversion and determined at contract inception. Hence, the dependence relation between the option underlying asset price and the exchange rate plays an important role in quanto option pricing. In this work, we suggest to use empirical copulas to price quanto options. Numerical illustrations show that the flexibility provided by this approach, concerning the dependence relation of the two underlying stochastic processes, results in non-negligible pricing differences when contrasted to other models.